Interest rate rise

[JPreston]

I don't know any economics. Despite working in financial services for best part of 10 years now

Can someone please tell what all this interest rate/inflation mularkey is about, what the one thing has to do with the other? i.e. why is it that because oil and energy prices have gone up interest rates need to as well?

[TheAnimus]

simplest way of thinking of it, and would be true in some kinda utopia is.

say i've £100,000 in a bond, now, i want that in 20 years time to buy me the same number of mars bars. Thats what a base rate should do.

Base rate goes up with inflation (wage prices rising etc) as it curtails overspending (spending of borrowed money). Thats the idea anyway.

There is the idea is a bubble will burst, everyone right now wants the 'soft landing' which america is thought to be seeing right now (cuased mostly by real estate prices).

So you can use base rate to control, provide inertia if you will.

By putting up the base rate, its more expensive to buy a house, so house prices won't rise so much.

The rise is triggered by your money been worth less, ie £100 not buying you enough energy to heat your home, and keep you in plasma tv.

Going back to mars bars, if someone introduces somethign truely stupid like a 'minimum wage' then all of a suden £4.90 an hour is worth less. Mars have to pay their workers more, so the price of mars bars rises. If the cost of a mars bar jumps to lets pretend £1, then the cost of living rises too. Its a vicious cycle, which is very complex too model via each parameter, so a sort of "black box" modeling is used (such as Haganization) to determine volatility, how likely something is too change (up or down). When something that is an everyday comedity such as tube fairs, jumps to something obsense like £4, all of a sudden £4 is worth much less, as such people on minimum wage end up working for 2 hours just too pay their transport fair. So that money is worth less, because it will buy you less.

Anyone who had their money in saving will of wanted it too buy the same amount of mars bars, so base rate is ment to reflect how much money devalues. Ie, 100£ will only buy as much as 105.25£. Thats base rate.

[Saracen]

I don't know any economics. Despite working in financial services for best part of 10 years now

Can someone please tell what all this interest rate/inflation mularkey is about, what the one thing has to do with the other? i.e. why is it that because oil and energy prices have gone up interest rates need to as well?

Simplistically put, inflation is bad for the economy, and it's the Bank of England's job to ensure that the economy performs to the targets set by the government - i.e. inflation targets.

Inflation figures for quite a while now have been above target, and edging higher. The sequence of rate rises we've seen in the last few months, and indeed the last couple of years, have been intended to take some of the pressure out of the economy, by reducing demand, thereby at least heading off further rises, if not perhaps letting inflation drop back.

Again, crudely put, inflation occurs because demand exceeds supply. If interest rates go up, mortgage payments tend to follow, which has two (main) effects. Firstly, if it takes money out of people's pockets, they can't spend it on cars, flat-screen TVs and other gizmos. If they can't spend it, it reduces demand while eases demand pressure and takes the inflation kettle off the boil a bit. Secondly, while one rate rise might not affect confidence much, a sequence of them does, because people start to wonder how much further it'll go, so they tend to put a little more of their income into savings, against the rainy day of further rises. If you reduce consumer confidence, again, you decrease demand and ease inflationary pressure.

However, as with many things, while a little may do the job, too much can be bad. If the BofE increased interest rates too far, too fast, it would risk severely damaging confidence and causing massive cuts in spending, and if demand drops too much, company order books aren't filled, unemployment goes up, causing demand to drop even further because the unemployed don't have wages to spend, .... and so on. In other words, you risk triggering a recession, especially if large rate rises popped the house-price bubble, because that wouldn't reduce confidence a bit, it would devastate it. And a recession, of course, isn't good for anybody.

So, what you're seeing with this rate rise, and previous ones, is the Bank of England indulging in tweaking the economy, a touch here and a trim there, to try and reach a balance between the economy growing at a sustainable, stable rate and yet inflation still kept to modest and also relatively stable levels, because if there's one thing business likes, it's the predictability dreived from stability.

Oh, one more point. Government has some number of economic tools at it's command, but most are quite slow to impact, and tend to be broad brush tools. If, for instance, the Chancellor chose to increase incometaxes, it'd be months before it started to impact, and when it does, it's effect is large. And if you want to turn it down again, it takes that months to impact. But if the increase interest rates today, the banks and building societies are likely to react within days if not hours, and it could well hit mortgage payments next month. And the BofE can do it again, little at a time, next month .... or can take it back down again.

Theoretically, the Bank of England are independent, and they set rates, not government. In practice, though, they have to meet targets set by government, and besides, while it might not be a formal instruction from government, I think it's naive to imagine the Bank don't know what the Treasury want, or will buck those wishes for long. So though it's one step removed, it is (in my view) really still the government calling the shots.

[badass]

And a recession, of course, isn't good for anybody.

Not true. Recessions are good for some forward planning people.
For example, they are generally a very good time to buy houses.

[Funkstar]

Good write up Saracen.

Badas is right though. For some poeple a recession can be very good. Unfortunitely for the masses, it isn't good for them, or the country as a whole in general.

[Saracen]

Not true. Recessions are good for some forward planning people.
For example, they are generally a very good time to buy houses.

Only if they didn't lose their job because of it.

Okay, it was a sweeping statement and I agree, there's exceptions. But everybody will suffer to an extent, because the economy goes down the toilet, which affects tax revenues, for instance, so either services are cut, or we all pay more tax. And those that don't earn enough to pay tax suffer because recessions tend to be highly inflationary times and prices go up far faster than either benefits or fixed incomes (like pensions). Oh, and if a pension is (as most are) based on stock market performance, you could find the pension fund itself in dire trouble, or even collapsing. It doesn't help to have a guaranteed pension if the fund that's paying it ceases to exist.

Yes, non-house-owners may well benefit. Or some of them anyway. Because, if house prices collapse, all owners have to do is ride it out, and not move or sell. So the only people in real trouble are those that can no longer afford mortgage payments, and so can't ride it out, and that's where negative equity comes in.

Yeah, it was a sweeping statement. But, by and large, true nonetheless.

[joshwa]

The news I saw made it sound like the countries debt was "out of control" - and a rise in the base rate would make borrowing money less appealling and saving more more appealling.

It's a good thing for people with savings accounts as their savings interest rate should increase making them more money, but bad for borrowers as they'll have to pay more money.

[chrestomanci]

The news I saw made it sound like the countries debt was "out of control" - and a rise in the base rate would make borrowing money less appealling and saving more more appealling.

It is true that Britan has much higher personal debt on credit cards and loans than most countries, but unlike most places the rates on those loans are not affected much by Bank of England rate changes. For the people who have all this debt this is probably a good thing as such people are often in a much more precarous situation than those who are not carrying large amounts of credit card debt.

On the other hand, I think this is a bit perverse. The Bank of England is trying to cut back consumer spending on things like flat screen TVs, that go on credit cards, but the rate changes take ages to trickle down to credit cards and loan, but affect morgages immedately.

It's a good thing for people with savings accounts as their savings interest rate should increase making them more money, but bad for borrowers as they'll have to pay more money.

Shame it takes so long for savings rates to get updated. Most building societies change their morgage rate within days, but take 2-3 months to change their savings rates.

[Saracen]

....

On the other hand, I think this is a bit perverse. The Bank of England is trying to cut back consumer spending on things like flat screen TVs, that go on credit cards, but the rate changes take ages to trickle down to credit cards and loan, but affect morgages immedately....

Yes, but when people expect to get hit in the wallet by mortgage rates (as many do), they curtail spending in anticipation. It's as much about perception and confidence as it is about actual money. And the perception gained from several successive rate rises is that things are going up .... and up and up. Shake people's confidence and complacency and they get nervous about the future, and tighten their belts a bit. Which is what the BofE want. They don't want spending to stop, they want it to ease.

[Funkstar]

there was someone on the news last night saying just that Saracen. He also said that it is probably quite clever timing by the BoE as people will be getting their christmas credit card bills in at about the same time as a letter telling them their mortgage rate is going up. So as you said this is more about perception than anything else. Those two things combined will get people thinking more about not spending.

One analyst was also saying that the BoE is probably acting now to avoid higher rises later, like a pre-empive strike. 0.25% now might avoid up to 1% later if things work out right.

[badass]

Only if they didn't lose their job because of it.

Okay, it was a sweeping statement and I agree, there's exceptions. But everybody will suffer to an extent, because the economy goes down the toilet, which affects tax revenues, for instance, so either services are cut, or we all pay more tax. And those that don't earn enough to pay tax suffer because recessions tend to be highly inflationary times and prices go up far faster than either benefits or fixed incomes (like pensions). Oh, and if a pension is (as most are) based on stock market performance, you could find the pension fund itself in dire trouble, or even collapsing. It doesn't help to have a guaranteed pension if the fund that's paying it ceases to exist.

Yes, non-house-owners may well benefit. Or some of them anyway. Because, if house prices collapse, all owners have to do is ride it out, and not move or sell. So the only people in real trouble are those that can no longer afford mortgage payments, and so can't ride it out, and that's where negative equity comes in.

Yeah, it was a sweeping statement. But, by and large, true nonetheless.

Agreed with all of that, I was just saying that if you plan things properly recessions aren't always bad for you

[Saracen]

Agreed with all of that, I was just saying that if you plan things properly recessions aren't always bad for you

It can be hard to plan for a recession. If you own a house, you could sell up in anticipation of a recession and falling prices. Trouble is, get that decision (or timing) wrong, and it either happens much later than you expect or not at all (especially given that selling a house probably will take months and cost you several grand in fees) and you could end up off the housing ladder, paying rent and losing out in house appreciation.

And even if you do get it right, there will be aspects of a recession that will hit even good planners. But yes, overall, it's possible to come out personally ahead, if the positive exceed the negative.

[Saracen]

there was someone on the news last night saying just that Saracen. He also said that it is probably quite clever timing by the BoE as people will be getting their christmas credit card bills in at about the same time as a letter telling them their mortgage rate is going up. So as you said this is more about perception than anything else. Those two things combined will get people thinking more about not spending.

One analyst was also saying that the BoE is probably acting now to avoid higher rises later, like a pre-empive strike. 0.25% now might avoid up to 1% later if things work out right.

Indeed. It's the micro-management thing I was talking about earlier. Small adjustments are better than big ones, or you risk setting off a kind of feedback cycle. A big rate rise triggers an over-reaction, so the BofE back off a bit and drop rates, so people think "phew, it's over", and start spending again, so the BofE have to act again, and perhaps with a bigger rate than last time because people will ignore the same again, because it didn't matter last time.

Before you know where you are, you're heading for a boom-bust cycle, which is exactly what business don't want, because the loss of stability damages long-term confidence and clobbers investment ... it just becomes too risky, because you can't predict either payback, or the long (or medium) term cost of borrowing.

[Rave]

Before you know where you are, you're heading for a boom-bust cycle,

I've been doom-mongering for months, and I'm not going to stop now. IMO all this is too late- we are heading for a massive bust; they're trying to lock the stable door now but the horse bolted years ago. Mortgage equity withdrawal has been a major source of new money entering the economy in the last few years (between 5-8% of all money spent if I understand it right) and when that supply of money dries up- which it will when the housing bubble finally stops inflating- the economy is going to contract. Right now I'm concentrating on paying off the last of my debts ASAP, then even if I lose my job I'm more or less safe- although as a bus driver I hope my job is fairly 'recession proof'.

[Saracen]

I've been doom-mongering for months, and I'm not going to stop now. IMO all this is too late- we are heading for a massive bust; they're trying to lock the stable door now but the horse bolted years ago. Mortgage equity withdrawal has been a major source of new money entering the economy in the last few years (between 5-8% of all money spent if I understand it right) and when that supply of money dries up- which it will when the housing bubble finally stops inflating- the economy is going to contract. Right now I'm concentrating on paying off the last of my debts ASAP, then even if I lose my job I'm more or less safe- although as a bus driver I hope my job is fairly 'recession proof'.

I'm not sure I can fault the logic. What's more unclear is the implications.

Sure, there's a huge level of consumer debt. But debt itself, even lots of it, is not necessarily a real problem providing it can be serviced. By that, I mean that even if you have lots of debt, it isn't a problem provided you can make the payments ... now and in the future.

Extrapolate that to a national level, and the question becomes (largely) not so much whether the housing market bubble bursts, but whether it bursts or slowly goes down. If we get a burst, a collapse in house prices and the resulting disastrous drop in confidence, we could well end up in a recession and house prices could dive.

If, on the other hand, the bubble doesn't pop, but slowly loses pressure (which could well be what modest, incremental base rate increases achieve), then the economy may not collapse, but may well stagnate or even deflate a bit. And if the government do what they keep threatening to do (a huge house-building program, especially in the most over-heated areas), then again, that argues for an easing of the situation rather than a collapse. At least in part, this is because even a large building program can only result in houses coming on the market at a modest rate, because building resources (skilled builders, etc) are a limited resource, and because building techniques in the UK imply a fairly slow process).

Lots of people think that because we had a collapse in house prices in the late 80s/early 90s, we're going to get another one. I certainly wouldn't rule it out as impossible, but before predicting such an event, we also have to consider that he economic background (and especially consumer confidence) were VERY different then to what they are now, and as I've said earlier, consumer confidence is absolutely fundamental to all this. It's probably the single biggest factor.

[JPreston]

...

Again, crudely put, inflation occurs because demand exceeds supply. ....

Ah, together with the rest of your post that was the missing link for me. I was confused because inflation is allegedly currently driven by oil and gas prices, and thought that reducing house price inflation was the main aim of interest rate rises, instead of just being the biggest target and so incidentally copping the brunt of the rises.

I knew it wouldn't be long before Rave would jump in with his housing bubble monologue .

I don't think anyone should say they would welcome a recession because their job is recession-proof, except maybe insolvency practitioners. I would imagine - with my non-knowledge of economics - that it's the lower waged in society who suffer the most in such cases because of increased competition for unskilled and semi-skilled jobs, making them likeliest to spend long periods out of work. Whereas those with wealth could weather it out much more easily.

Following on from the longest period of economic growth basically in the history of mankind, there's probably lots of smug homeowners who have nothing to fear from a spell of 15% interest rates and a 20% house price crash this time around. I'd probably just use the opportunity to buy a much bigger house. Can't touch me, ner-ner...